Financing a Business Dr. Clive Vlieland-Boddy Core areas of the module • Financial management function • Financial management environment • Working capital management • Investment appraisal • Business finance • Cost of capital • Business valuations • Risk management The Financial Management Function The Financial Management Function • Raising finance • Investing funds raised – this includes • allocating funds and • controlling investments • Dividend policy – returning gains to shareholders Corporate Strategy & Objectives Corporate Stakeholders Agency Theory • Agency relationships occur when one party, the principal, employs another party, the agent, to perform a task on their behalf • Objectives of principals and agents may not coincide • Problem of goal congruence FINANCING ACTIVITIES • The balance sheet – Summaries Assets & Liabilities. – Current assets are financed with current obligations – Long-term debt and equity finances long-term assets • You should not finance long term assets with short term funds! • Debt and Equity Capital: Two Basic Sources of Funds Sources of Funds • Debt capital—funds obtained through borrowing. • Equity capital—funds provided by the firm’s owners when they reinvest earnings, make additional contributions, or issue stock to investors. Financial Management -Internal Sources of Funds Profit The after-tax profit earned and retained by a business which is an important and inexpensive source of finance. These are the Retained Earnings of the business. A large part of finance of most businesses is funded from profits left in the business. Comparison of Debt and Equity Capital Type of Funding Short Term • This should only be used for short term needs. This means that financing Non Currents Assets should NOT be funded with short term money. Long Term • This means that it borrowed for more than one year. Short Term Money • Bank overdraft • Here the company arranges a facility with its bankers to allow funding to cover short term cash flow issues. • Accounts Payable can enable working capital to be funds short term problems. • Inventory management or Credit control can also help. Long Term Money - Equity • Retaining Earnings and not paying dividends. • Issuing more new shares. • M&M’s view of this! Long Term Money - Debt • Debt by way of a loan for 1-20 years. These will be advanced against the 3 key requirements: – Security – Serviceability – Commitment • Remember debts interest and repayments have to be made on due dates. • Tends to be less expensive than equity due to risk and tax shield. Capital Structure Debt and Equity • The basic feature of a debt is that it is a promise to repay a fixed dollar amount of by a certain date. • The shareholder’s claim on firm value is the residual amount that remains after the debt holders are paid. • If the value of the firm is less than the amount promised to the debt holders, the shareholders get nothing. Debt Vs Equity • Interest and Capital repayments have to be made in accordance with the loan agreement. • Dividends are only paid to shareholders if there is money available. Debt & Interest • These always have to be paid. If not the company is insolvent and likely to go bankrupt. • Interest is based on what the lender requires. It is usually a market rate. Currently say 5%. • Interest is tax deductable. • This means the net cost of borrowing by way of debt is reduced even further. • Say 5% interest less tax at 30% means net cost is only 3.5%. • This tax benefit is called the Tax Shield. Equity & Dividends • Whilst nice, dividends don’t have to be paid. • Dividends are not tax deductable. • Equity investors are usually greedy demanding substantial returns usually in excess of 20%. Question • Why if Debt is only 3.5% net and Equity is over 20% net, aren’t all companies 100% debt financed? • The issue is that there is a commitment to pay the interest and repayments of the debt. In good times this is not a problem but when things start to go wrong then they are. FINANCIAL LEVERAGE Financial leverage concepts – The traditional view is that an optimal mix of debt and equity exists – Research demonstrated that the mix of debt and equity is irrelevant, if taxes are ignored – The tax deductibility of interest expense creates an advantage for incurring debt FINANCIAL LEVERAGE (CONT.) • The advantage of debt only exists up to a point – Low cost debt increases ROE relative to ROA – Debt can become so costly that it reduces ROE below ROA Leverage • Leverage is the technique of increasing the rate of return on an investment by financing it with borrowed funds. • The key to managing leverage is ensuring that the company’s earnings remain larger than its interest payments. • This increases the leverage on the rate of return on shareholders’ investment . • Many say that all companies should be 100% debt finance but that ignores the risk of bankruptcy factor.
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